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The journey of a thousand miles begins with one step.” - Lao Tzu

In a tiny first step on December 16, 2015, the Federal Reserve (Fed) did something they had not done in over nine years. From the unprecedented starting point of zero, they raised the Fed funds rate. Since, they have begun to allow their swollen balance sheet to contract in what can only be characterized as another unprecedented event. Although monetary policy remains extreme and real rates only recently have turned positive, these measures mark the end of an era of maintaining extreme financial crisis monetary policy in the United States.

Reversing these experimental policies initiates a new set of dynamics which will gradually reduce excessive liquidity from the financial system. Just as quantitative easing (QE) and zero interest rates were a grand experiment, the removal of these policy measures is equally experimental. Now, over 325 million domestic lab rats and the rest of the world wait to see how it plays out. Importantly, if the Fed continues down this path, investors should carefully consider potential risks and the appropriate market exposure in this brave new world.

Despite the multitude of unanswerable questions about the implications of these events, what we know is that the economy is in the late stages of an economic expansion. Just as low tides follow high tides, we can use prior cycles as a guide to consider prudent, late-stage portfolio positioning.

Market expectations

As discussed in, Everyone Hears the Fed but Few Listen, the difference between Fed officials’ expected path of Fed rate hikes and market expectations for the Fed Funds rate is important. The implications for the market and investors are especially compelling when considering asset allocation weightings. For example, if the Fed continues on their path of more rate hikes and surpasses market expectations, stocks are likely to struggle as much needed liquidity evaporates. The bond market, on the other hand, will probably continue to do what it has been doing, but to a greater extent. A flatter and possibly an inverted yield curve would be in order unless inflation rises by more than is currently expected. Conversely, if the Fed backs away from their current commitment, it will likely be bullish for risk assets and the yield curve would probably steepen, led by a decline in two-year Treasury yields.